BIS is right to worry about clearing risk, concentrating it well, concentrates it

The Bank for International Settlements - often described as the central bankers’ central bank - is worrying about central clearing houses. They’re right to do so, for concentrating risk into the one place doesn’t make risk go away:

The pillars of the global financial system are fundamentally unstable and could lead to a frightening chain-reaction in the next crisis, the world’s top watchdog has warned.

Giant "central counterparties" (CCPs) that clear much of the $540 trillion (£428 trillion) nexus of derivatives are themselves vulnerable to failure in times of extreme stress.

Entirely so and there’s not really a solution here either. There’s an optimal position to each but no actual solution - w’re in that economics lesson where there are no solutions, only trade offs.

As the perceptive expert on the subject Craig Pirrong has been detailing for some time now any insistence that everything be cleared through the one or few clearing houses does indeed risk creating another too big to fail component of the system.

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place.

The underlying points being that if everything is running through the one or three points then, in the absence of crisis, that’s efficient. One clearing house means just the one stock of capital to meet margins, it being possible to offset the requirements for different positions and thus only be consuming the net amount to support the net position. This makes the laying off of underlying risk - the point of such markets in the first place - cheaper and that’s a good thing.

But, of course, having all the risk on one place means that in extremis we’ve all the risk in one place, making that one node of the system too big to fail. We simply cannot afford to let it fall over. And, sadly, at the real extreme ends of the long tail of possible events there’s a possibility that it will attempt to fall over.

We’re in the same sort of bind as we are over fractional reserve banking itself. That system has the inherent instability of possible bank runs, yet in more normal times the system is societally wealth enhancing. We can manage - say with central bank support - the risks but we cannot make them go away entirely. The same is true of central clearing. BIS is right to worry.

The best solution being to work through, as Pirrong says, what we’d do if there was that failure. And most certainly we’ve got to acknowledge that it could happen. We’re in that reality where we’ve no perfect solutions, only trade offs of greater or lesser desirability.